Leverage Is Speculation Defined

We first discussed stock options last week (the kind you can buy and sell, not the kind granted by companies), and we focused on risk and a defensive strategy. If you didn't read that column and options are new to you, please visit it before reading this column.

Last week, we explained buying "put" options to protect a gain in a stock you already own. Buying protective puts is most logical when the stock you're protecting is volatile -- both to the upside and downside -- and has great risk but also room for strong reward. If you want to protect yourself on the downside while not limiting your stock's upside potential, a put works as insurance by setting a price bottom at which you may sell.

Buying a put gives you the right (but not an obligation) to sell the underlying stock at a set price within a set time. Today, we'll discuss its opposite: a call option, which gives the owner the right to buy a stock at a set price before the option expires.

The case for buying put optionsBefore we jump into call options, the case for buying puts is worth a review. Yes, you may use puts to protect an existing position -- but that said, you don't often use protective puts alone, because they're usually expensive (we'll discuss how they're often used next week). The other reason for buying puts is more straightforward: You can buy puts when you think a stock is ripe for a fall and you'd like to short the stock. Because compared to shorting stocks, buying puts is a less risky way to anticipate a decline.

A put that gives you the right to sell a stock at $20, say, will increase in value as the underlying stock declines below $20 (and you needn't own the stock to own the options). Therefore, buying puts is an effective way to short a stock without risking untold sums should the stock soar. With a put purchase, the amount of your purchase is your only financial risk, and your only enemy is time, because the option could expire before the stock declines.

Those two uses (protecting a position or betting a stock will decline) are the primary reasons for put ownership, simplified. Buying calls is another story.

A lesser case for call optionsThe main reason for owning call options is leverage. Buying a call is a bet that a stock will rise above your option's strike price before the option expires. Call options are considerably more risky than buying a stock outright, because the option expires within months (for this reason, longer-term LEAPs are preferred) and if the stock doesn't rise by then, your money is gone. So, why risk it at all?

Well, call options give you much more buying power, or leverage, so they can pay off handsomely -- when you're right -- while risking much less capital.

Let's use a real-life example. Currently, Microsoft (Nasdaq: MSFT) trades at $24 per share and appears to be a good value. Let's say you believe that by January 2005 the stock will be considerably higher. Looking at Microsoft's option prices, a January 2005 call with a $20 strike price (which is the right to buy Microsoft at $20 anytime between now and January 2005) currently costs $7 per contract.

That option price implies $4 in intrinsic value (the difference between the share price and option strike price -- $24 minus $20) and $3 in "time value" (what could happen over time to the stock price), accounting for the next 19 months, to January 2005.

If you want to control 1,000 shares of Microsoft, you could buy 1,000 shares of the stock for $24,000, or you could buy 10 call contracts at $7 for $7,000.

If Microsoft rises to $34 by option expiration, your option would be worth $14 a contract, for a 100% gain. If you'd bought the stock itself, you'd have a 42% gain. You'd make $7,000 on your $7,000 option bet. In comparison, you would have made $10,000 on the stock by investing $24,000. So, using less than one-third the capital, you would earn 70% of what you would have made had you bought the stock outright. Extreme leverage.

That's the main advantage behind owning call options. You can participate in more of a stock's upside using less capital than you would need to buy shares. However, the downside is much uglier.

Assume Microsoft is only $19 by January 2005. Had you bought the stock, you would be down $5,000. Owning the option, however, you lose all $7,000 invested and have no recourse. At least owning the stock you would hope for a rebound. Because of this very real danger, buying call options is extremely risky, and I think it's rare that you should purchase them rather than simply buying the stock (in a lesser amount if need be) outright.

SummaryAny investment vehicle that can expire worthless is high speculation, so it should offer specific, strategic advantages. Buying calls merely offers the advantage of leverage (controlling more shares for less money), and leverage is just speculation defined.

Options are useful tools to protect positions (by buying puts), and options offer risk advantages when shorting stocks (again by buying puts). Options are also useful to get you into a stock at a lower price, or to sell you out of a stock at a higher price (you can do that by selling, or writing, options -- we'll discuss this disciplined strategy next week).

However, buying calls in hopes that a stock will rise by a specified time often makes less sense than buying the stock itself, in my opinion. But if there's room in your portfolio for speculation, and you want more potential bang for bucks that you're prepared to lose, then buying longer-term calls is something to consider -- especially after three years of a down market. To discuss all this, visit the Fool on the Hill board.

[Jeff congratulates his sister, Patty, who was valedictorian of University of Iowa's School of Nursing -- and she didn't even trip while walking up. Some newborn babies are in for a good welcome to the world.]

Jeff Fischer doesn't own a position in companies mentioned. The Fool has a disclosure policy.

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